Euro 'irreversible', membership not

Bittersweet ECB message after 20 years

by OMFIF Analysis

Wed 20 Jun 2018

The euro is irreversible, but the composition of the countries in Europe's single currency is not. That was a central bittersweet message delivered to the audience at OMFIF's 18 June London seminar commemorating the 20th anniversary of the European Central Bank's establishment on 1 June 1998. Other conclusions were that debt restructuring within the euro area – including possibly for a large euro member such as Italy – was virtually inevitable at some stage; that the ECB had become increasingly politicised over the 20 years; and that the ECB was ill-prepared for a future international recession.

The seminar heard considerable discussion on the rising volume of the German Bundesbank's Target-2 claims on the ECB, which reached €956bn at end-May and seem likely to pass the €1tn mark in the next few weeks. This is an indication, according to some, that economic and monetary union has already become a 'transfer union' under which creditor countries automatically channel long-term funding to debtors.

A break-off from the euro area of some problem countries, although thought possible in coming years, would not be a simple task. There was a solemn warning, apposite in view of indications about possible euro departure from politicians close to the populist Italian government, that leaving the single currency would be a highly complex and damaging procedure with legal, economic, political and technical ramifications not hitherto experienced.

As a result, the seminar included a discussion of whether debt restructuring might take place within the present euro area with member countries remaining intact but debt written down. This could take place under similar rules to those discussed for a sovereign debt restructuring programme by the International Monetary Fund in the early 2000s – and more recently suggested by a group of Franco-German economists.

OMFIF's panel for the off-the-record discussion included Jürgen Stark and José Manuel González-Paramo, former ECB executive board members in 2006-11 and 2004-12 respectively, Lord (Adair) Turner, former chair of the UK Financial Services Authority, and John Kornblum, former US ambassador to Germany. The discussion was chaired by David Marsh.

Stark was previously state secretary at the German finance ministry, where he played a key role in setting up the euro in the late 1990s, and vice-president of the Bundesbank. Stark resigned spectacularly from the ECB in 2011 after a dispute over the central bank's government bond-buying exercises to support weaker EMU members and especially its negotiations on conditionality with the Italian and Spanish governments, which he claimed infringed the bank's independence. González-Paramo is an executive board member of BBVA, the Spanish bank, while Turner is chair of the Institute of New Economic Thinking.

Kornblum played a delicate role in the euro's formation when he travelled to Europe in 1997 at the behest of Lawrence 'Larry' Summers, US Treasury secretary, and Alan Greenspan, chair of the Federal Reserve, to explore thinking on the setting up of the new currency and investigate Europe's reaction to American scepticism and hostility.

Here are eight highlights of the discussion:

1. Monetary andeconomic outlookThe ECB decision to leave interest rates in negative territory at least until summer 2019, at the same time as deciding to phase out its €2tn-plus quantitative easing at the end of 2018, was a relatively dovish decision. This would give the central bank less leeway to ease policy when the next world recession strikes, which could be as early as 2020. The US federal funds rate by that time may be at 3.5%, representing a massive widening of the US-European interest rate spread. Mario Draghi, the ECB president, would have been better advised to start tightening earlier. Since this has not been the case, Draghi will bequeath to his successor a somewhat accommodative policy that will be difficult to reverse sufficiently to give the ECB ammunition to cut rates when the inevitable slowdown emerges. Europe's economic situation had improved principally because of Chinese and US fiscal stimulus. High debt remained an important economic risk within the euro area, and Italy was in fundamental need of debt restructuring – but accomplishing this would be supremely difficult.

2. Potential euro departuresThe euro area was very close to losing one of its members in 2015 when Germany and other countries advocated the departure of Greece, an idea backed by some in the Athens government. The country pulled back from the brink. Greece (and even more so Italy) remains a weak link. Two speakers mentioned the need for Italian debt restructuring, or otherwise face leaving the euro. But exiting the single currency would be extraordinarily difficult and complicated. If Italy were to leave the euro, it would choose to convert all domestic wages, prices and contracts into 'new lira'. However, that would not apply to international contracts, where there would be considerable disputes: 'This would be a field day for lawyers.' There would be big differences in the treatment of lending in euros to an Italian borrower from, say, US banks' branches and subsidiaries in different European jurisdictions, and a loan by an indigenous European or Italian bank. The ECB has said that, if a member country departed, it would have to settle all outstanding balances under the Target-2 system. It is not clear how that could be done. Italy would certainly refine its Target-2 debt to the Eurosystem in devalued 'new lira' and not in euros.

3. Central banking powerThe ECB is the most powerful and effective institution in Europe – and the only institution capable of making quick decisions. There was an element of 'self-empowerment' in this, but governments had been pleased to transfer influence to the ECB since it was the only institution equipped to take decisive action. Public support had held up quite well despite the euro's difficulties – 70% of euro area citizens support the euro. An unwelcome paradox – ECB has been very successful at fulfilling its mandate, which is price stability. The ECB has now gone beyond its mandate with QE and (together with the build-up of its powers in other areas, especially banking supervision) has become the effective guarantor of the euro system. The ECB would be more effective when its mandate is kept narrow, but there is no perspective that the bank will ever retreat to its previous narrowly defined objectives. It seems likely to maintain its relatively high balance sheet and 'toolkit' of measures to influence the economy.

4. Disagreement over deflation riskThere was disagreement among the panellists of whether a risk existed in 2012-15 of malign deflation in the euro area and whether the ECB's large-scale government bond-buying programme, which started in March 2018 and is now being phased out, was justified. 'There was no risk of a downward spiral' [in prices], one panellist said, claiming that the fall in inflation was due above all to an 80% decline in the oil price. Another said unconventional monetary policies were justifiable in unusual circumstances.

5. Price of recoveryThe EU should be more proactive and not simply wait until the next crisis to enact reforms. There was agreement that the ECB had been successful in holding the euro area together, with the ECB saying that QE had added 1.9 percentage points to growth and inflation between 2016-20, but this had come at a price. The disbenefits included increased 'moral hazard' as result of the ECB's bond-buying as well as a creeping politicisation of ECB decisions in view of the expansion of the central bank's activities both as a banking supervisor and as a 'lender of last resort' to governments.

6. Low interest ratesOne important lesson of the past 10 years was that low interest rates were not a panacea for dealing with sluggish economic growth caused by a correction to unsustainable private debt and the subsequent balance sheet recession. European GDP had barely recovered from the position before the financial crisis, despite low interest rates and QE, which had led to market distortions, further skewed distribution of wealth and heightened moral hazard. Among proposals for reforming the euro area were measures to complete the banking union, further progress in banking supervision, fresh steps in forming a capital markets union, partial substitution of national issuance of debt through joint issuance in a European redemption fund as well as a euro area budget that could apply 'shock absorbers' at times of economic downturn. The Bundesbank was right in the 1990s in saying that a strong element of political union was required to make monetary union work.

7. Washington manoeuvresWashington opposed the Maastricht Treaty in 1997, where some regarded it as 'the devil's own work'. John Kornblum was sent on a mission to explore what harm the US stance was doing. He formed the impression that this policy was damaging US chances of forging a consensus in other areas, such as over Bosnia and the Balkans. He was also told that overt US opposition would strengthen Europe's determination to go ahead with the euro. Kornblum reported back to Washington and achieved success in mitigating Treasury Secretary Lawrence Summers' remarks, less so with Alan Greenspan, who modified some statements but still claimed the euro was a mistake.

8. Europe and the worldOne panellist said Europe is falling behind the US and China in global influence. 'The world is moving at the speed of light and Europe is not in the frame.' Germany was said to be the one European country that understood the implications of the pace of change, but were held back by the desire of other countries for the Germans to show 'solidarity', which could end up depressing German and European economic prowess and preventing Europe from reaching the levels of China, the US and Japan.